Energy Finally Beginning Bottoming Process

After multiple attempts to put in a bottom, the oil and gas markets finally seem to be working their way to definite bottoms. Don’t jump in with both feet just yet though, bottoming is a process and as we’ve seen, it can be a very painful one. Friday’s jump in crude of 12% wasn’t even enough to make it a profitable week for oil. Our short oil trade earlier last week did very well. I expect more bets against oil to do well as it works its way to a bottom with a price per barrel in the teens for a day or two this spring. 

Oil Production & Consumption

This week we have already seen Russia and Saudi Arabia “agree” to not produce more oil. The markets, the dumber corners of it, applauded the inaction and bid oil prices up a bit. We will be seeing another meeting Wednesday, this time between Iran, Iraq and Venezuela. Don’t expect any cuts in production there either. Iran over the next year or so will add a million barrels of crude per day to the market and Iraq is likely to increase production as well, albeit at a slower pace than they have been in the recent past. 

Iran is already saying they will not take part in any coordinated cuts until they reach near their pre-sanctions production. Given their cost of production and need for the money, this is understandable. Other OPEC nations increased production while Iran was on sanctions, which Iran points out shouldn’t preclude them from returning to prior levels. Iraq after years of war began has seen dramatically increased production in the past few years. Looking at the charts below, it is difficult to see who is willing to cut. Libya clearly would like to add about a million barrels per day.

OPEC 5 Year Production ex-Saudi Arabia

The chart above does not include Indonesia due to unreliable statistics, however, as a net importer I think we can put them aside for now. Below is a chart of Russian and, Saudi Arabian output the past five years. While Russia has increased production, we know that is leveling off due to constraints in its oil fields. So, agreeing to a production freeze was not a big deal for them as their production is going to level off no matter what.

Saudi Arabia has had a lot of variability as a swing producer over the years as you can see. As one of the lowest cost producers though, what incentive do they have to cut? Also, what does it say that they are talking about IPOing Saudi Aramco? Given that Russia and American companies are difficult to reign in due to being non-governmental, I think it says that is an excuse for producing more that they want too. As the lowest cost producer, they’d win that battle.

Saudi and Russian Oil Production

Oil Production and Operating Costs by NationHere are the costs of oil production for the OPEC and other nations. Again, I urge you to think about what is going on here. The low cost producers are simply forcing out the high cost producers. OPEC (and Russia) only need to get rid of about 3 million barrels a day of competitive production to be able to sell all they can produce.

North Sea production is at huge risk – see U.K. costs. Brazil has been suffering to the point of being in a depression. Canadian companies have been dramatically cutting capex. Essentially, all the nations with more expensive production than large producer United States are going to have to be very selective in what they choose to develop, especially in a world where demand is peaking right now and will turn over as electric cars become more popular.

So, as about 3 million barrels per day from higher cost producers dissipate through depletion that is not replaced by new production (capex reductions) then we will see oil prices move higher eventually. The concern I have for later this decade is whether or not we see an oil price spike. I think we might because electric cars I don’t think pick up fast enough to dent total demand until the 2020s and the capex reductions so far appear to be enough to reduce non-OPEC production by well over 3mbd by 2018.

So, in the very short-term, possibly through May, which is just ahead of the next currently scheduled full OPEC meeting, there will likely be huge pressure on oil prices to bottom. I think it is very likely that OPEC reaffirms that they are going to do little in the way of production management which would help solidify the bottom for oil, possibly with a double or triple bottom below $20/barrel. By then however, another wave of bankruptcies will have hit the oil and gas sector setting up for a rapid rise in oil prices back to the “normal range” I identified in June 2014 when I first discussed a large drop in oil prices. The only real question I have left is whether we will see the type of 2 or 3 year price spike up in a few years, essentially a mirror opposite of the price plunge we are finishing now.



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